Bernard's Top 10: The problem with CoCos; Deutsche Bank's astonishingly high leverage; How long will China's currency reserves last?; The problem of China's unpaid migrant workers; Get rid of the big notes; Clarke and Dawe on Europe's debt crisis

Here’s my Top 10 items from around the Internet over the last week or so. As always, we welcome your additions in the comments below or via email to

See all previous Top 10s here.

My must read is #4 on CoCos. Another opaque financial product that could disrupt the financial world…

1. The problem with ‘CoCos’ – I remember back in 2008 and 2009 when I was doing daily Top 10s how I kept stumbling over exotic new financial instruments (they always had bland acronyms) that appeared to be just about to blow up the world’s financial markets. There were CDOs (Collateratlised Debt Obligations) and Credit Default Swaps (Credit Default Swaps). There were even synthetic CDOs, which combined those two instrument into toxic debt bombs that almost took down the global banking system.

Now I’m having to understand another exotic instrument that is worrying an awful lot of people on global financial markets.

As our chart on CDS spreads for Australasian corporates (which means banks mostly) shows, stress on global credit markets is growing. That’s mostly because people are nervous about whether highly leveraged European banks, which have yet to have the real cleanouts that American ones did, will be able to pay the interest on the ‘CoCo’ (Contingent Convertible) bonds they’ve issued. These bonds are designed to convert from debt into equity in a bank if a bank is stressed.

On Monday night one analyst suggested that Germany’s biggest bank, Deutsche Bank, might not be able to pay the interest next year on its CoCos. Its share price slumped, and so did those of plenty of other European banks. The bank rout has since spread into Japan and Australasia, although to a lesser degree.

So what are CoCos?

Here’s a good FT backgrounder:

At a simple level a company has owners, and it borrows money from lenders who expect to get their money back. If the business runs into trouble, the owners lose their stake and the debt becomes equity — lenders turn into owners — in what can be a drawn-out process of restructuring.

Because a bank in trouble would not have time for such negotiation, coco bonds are designed to anticipate that process and transform automatically from debt to equity when certain conditions are met. Their full name is tier one contingent convertible bonds, and most are also known as additional tier 1 capital (AT1 bonds).

They have their roots in the financial crisis, when governments were forced to bail out banks. Devised to help rebuild the capital that regulators require banks to hold in case of losses, cocos pay a fixed coupon, but convert to equity or can be written off when losses force a bank’s capital below a certain threshold.

They also allow the issuer to miss coupon payments, and this prospect no longer seems remote, setting off the latest bout of market anxiety.

Cocos are the riskiest debt issued by banks, with only a quarter of the eurozone market judged investment-grade by credit rating agency Fitch last year. Retail investors are not supposed to be involved in the €95bn market where coupons are high — frequently 6-7 per cent, compared with below 1 per cent for senior bank debt — to compensate for the risk of loss-absorption, and the risk that payments will be halted.

2. Keep an eye on Italy – As John Rubino points out here, the Italian banks are the least safe of all those on the continent. The chart below is enough to get an idea of why some people are worried. 16% NPLs. Hmmm. How might that end?

All eyes are therefore on Italy’s Banca Monte dei Paschi, which has a non-performing loan ratio of 33% and, as a result, a plunging share price. When the Italian economy finally blows up, this will probably be where it starts.

But here the story takes an even more disturbing turn. It seems that the other lender now spooking the markets is none other than Deutsche Bank, pillar of the world’s best-performing economy. Shockingly-bad recent numbers have combined with questions about its mountain of derivatives and exotic debt to put DB in a very uncomfortable spotlight.

3. It’s always, always about leverage – FT commentator John Kay is in New Zealand at the moment and he’s also sceptical about Deutsche Bank. The numbers are startling.

Here he is talking to Jenny Ruth at the NBR:

“In the case of something like Deutsche Bank, the complexity and scale of its exposures are such that it’s not really credible that the management of the bank itself has any deep understanding of the scale and nature of the risks.”

Professor Kay says Deutsche Bank’s liabilities are more than €50 trillion, three times the value of all Germany’s assets.

But the bank’s capital base is just €50 billion, or zero-point-one percent of its liabilities, so even doubling that capital wouldn’t make any practical difference.

4. Nervous about US$102 bln of CoCos – Bloomberg also has a useful summary of the situation bubbling around Europe’s CoCos and why it’s unnerving global credit markets. The chart with the spike at the end gives an indication. Just a quick reminder that rising CDS spreads globally mean it’s slightly more expensive for New Zealand’s banks to roll over their foreign debts, which in theory would get passed on to New Zealand mortgage rates. Which is why many are calling for the Reserve Bank to cut the OCR again to offset this effective tightening.

Investors are increasingly concerned that weak earnings and a global market rout will make it harder for banks to pay the interest on at least some of these securities, or to buy them back as soon as investors had hoped. The bonds allow banks to skip interest payments without defaulting, and they turn into equity in times of stress. Deutsche Bank may struggle to pay the interest on these securities next year, a report from independent research firm CreditSights earlier on Monday said. The bank took the unusual step of saying that it has enough capacity to pay coupons for the next two years. 

“The worries about these bonds represent real fears that the European banking system may be weaker and more vulnerable to slowing growth than a lot of people originally thought,” said Gary Herbert, a fund manager at Brandywine Global Investment Management LLC, which oversees about $69 billion in global fixed-income assets. “It’s the epicenter of growth concerns globally. And it doesn’t look pretty,” he added.


5. It’s always, always about risk-related yields – One reason so many people piled into CoCos over the last couple of years is that interest rates in regular bank deposit accounts and bonds in Europes had been driven to 0% and even lower by the ECB’s easing of monetary policy. Over US$7 trillion or a third of the word’s government bonds are now charging negative interest rates. Twas ever thus. Remember how attractive the 10% offered by property finance companies looked in 2007?

Here’s Bloomberg with more on these CoCos:

The notes were issued in Europe and offer some of the highest yields in credit markets, at an average 7 percent, compared with an average yield for European junk credits of less than 6 percent, according to Bank of America Merrill Lynch indexes.

But critics say banks are too opaque, the notes are too complex to be properly understood, they’re too varied and they’re too much like equity to be considered bonds. With so many unknowns, the risks are high.

“Basically you have the upside of fixed income and the downside of equity,” said Gildas Surry, a portfolio manager at Axiom Alternative Investments. “AT1s are instruments of regulators, by regulators, and for regulators.”

Investors are not just concerned about banks missing interest payments, they are also worried about whether banks will redeem the notes at the first opportunity. Rising borrowing costs may make banks less likely to redeem the notes, which would force investors to hold the bonds for longer than they had hoped.

 6. Is US$3 trillion enough? – The other dominant theme on global financial markets in the last couple of weeks is how quickly capital fleeing from China and how soon before the People’s Bank of China has to stop intervening to hold the yuan up and either let it float lower, or impose much harder capital controls. China released figures on Sunday showing the stockpile fell US$100 billion to US$3.23 billion in January.

A lot of people just point to that big number and say that China has lots of room and time to just slowly whittle away those reserves.

But, as Christopher Balding writes via Bloomberg, that may not be the case, pointing out that US$1 trillion of those reserves are illiquid and the IMF recommends it hold a minimum of around US$3 trillion anyway.

Depending on exactly how fast capital leaves China, Beijing could be looking at a worryingly low level of reserves as soon as July. At current rates, China will drop beneath the recommended amount of $3 trillion at the end of the first quarter even if including all illiquid assets; excluding them, China could have fewer than $2 trillion in usable reserves by summer. By the end of the year, the government could face a situation where the only tools left to prevent the currency’s slide could be hard capital controls that prevent money from leaving the country — an embarrassing state of affairs for the world’s second-largest economy.

How should Chinese policymakers respond? First, they have to accept that the financial laws of physics apply to China. The PBOC may have a good case to lower interest rates. But with loan demand down, fears rising over equity markets, and a huge overhang of surplus capacity, further monetary easing is sure to prompt additional outflows as investors seek higher returns elsewhere. That means continued downward pressure on the yuan, forcing the PBOC to spend billions more to buy up the currency.

By seeking both looser monetary policy and a strong yuan, the central bank is pursuing a set of contradictory policies that can’t succeed. The PBOC needs instead to chart a course toward either floating the yuan or imposing capital controls. There simply are no other alternatives.

7. The other problem with China – As the economy has slowed down, some firms have stopped paying their workers. The current Chinese New Year holidays are an important time for many workers, who expect to get paid New Year bonuses and be able to take money home to their families.

There are a few problems with that this year, Reuters reports. Unrest is rising.

While the housing sector is among the worst-hit in China’s economic slowdown, the pain is being felt by blue- and white-collar workers in other industries.

According to Geoffrey Crothall of the Hong Kong-based group China Labor Bulletin, which tracks worker issues, there was a spike in protests in the last quarter of 2015.

Its data show that in December and January, there were 774 labor strikes across China, from 529 in the previous two months, most of them over wage arrears.

At a printing factory in the western city of Chongqing, a Reuters reporter was present when a local official visited last week to make sure the boss paid his workers before the Year of the Monkey begins.

The official declined to speak with Reuters, although the boss later said it was an attempt to prevent unrest.

“That’s what the government is most fearful of,” said the factory owner, who did not want to be named.

8. Capital flight is a lot like a bank run – One of Australia’s most prominent fund managers reckons capital flight could cripple China’s economy. This flight is rational and fueled by Chinese citizens’ deep distrust of their own Government, he says via SMH.

Vimal Gor, head of income and fixed interest at BT Investment Management, argued that trying to assert control over money fleeing an economy’s borders can be a bit like preventing a run on a bank.

“The market sees capital outflows and devaluation more akin to what a failing bank looks like in its final days – a bank run precipitating a falling stock price, which encourages further doubt and so on,” the fund manager says in his widely followed investor newsletter.

“The capital outflows are the depositor withdrawals and the exchange rate is the stock price. This is because similar issues around opacity affect banks as well. When a bank run is occurring, as Mervyn King, ex-governor of the [Bank of England] once said, it is rational to participate in it.” 

Part of China’s problem is that its capital controls have proved incredibly porous and money is still leaving the country despite restrictions imposed by financial institutions. The depreciation of the yuan, which began in earnest in August 2015, has not deterred wealthy Chinese from trying to move their cash abroad.

“For those in power, moving this money overseas is the rational thing to do, and should be independent of whatever the exchange rate is,” Mr Gor said. “This means that FX reserve depletion could well be the actual trigger for a hard landing in China, rather than a collapse of the banking system, which is still clearly under the party’s control.

Mr Gor argues that the wealthiest members of China’s population maintain a deep distrust of policymakers, and Beijing needs a new strategy. 

“This is driving the capital outflow, which has resulted in devaluation, but the real risk will be if it eventuates that a 20 [-plus per cent] devaluation doesn’t stop the flow of capital out of the country.”

9. Get rid of the big bills – One step short of abolishing cash altogether is to to simply get rid of the really big notes, which most of us don’t use for legitimate reasons.

Here’s a Harvard paper proposing removing the US$100, 500 euro, 50 pound and 1,000 Swiss Franc notes from circulation to make life difficult for drug dealers, kleptocrats, tax evaders and smugglers. New Zealand’s NZ$100 bill would fit in this category. I agree with this and it would get around the objection some have to still using cash to buy small items.

Such notes are the preferred payment mechanism of those pursuing illicit activities, given the anonymity and lack of transaction record they offer, and the relative ease with which they can be transported and moved. By eliminating high denomination, high value notes we would make life harder for those pursuing tax evasion, financial crime, terrorist finance and corruption. Without being able to use high denomination notes, those engaged in illicit activities – the “bad guys” of our title – would face higher costs and greater risks of detection. Eliminating high denomination notes would disrupt their “business models”.

10. Clarke and Dawe on the European Debt Crisis – This is from July 2010 and seems strangely prescient….again.